Global clouds cast a shadow over local rate cuts

Investors are preparing for further rate cuts over the next year but easing monetary conditions could be overshadowed by the global economic clouds, experts warn.

Global economic woes are expected to make the Reserve Bank of Australia’s job of stimulating the local economy more complicated as sharemarket performance is an important driver of consumer confidence.

“If the RBA cuts the cash rate to around 2.5 per cent as what the market is expecting, the rate cuts will be ineffective," Credit Suisse strategist Damien Boey said.

“If the RBA is prepared to cut into the 1s [1 per cent plus], then we have a chance of resurrecting some of these domestic cyclical stocks."

Investors are expecting the cash rate to fall a further 0.86 of a percentage point from its current perch of 3.5 per cent over the next 12 months, based on the Credit Suisse interest rate index.

Lower interest rates lower the cost of debt and that usually improves the profitability of cyclical companies. These include consumer discretionary companies (such as retailers) and those involved in housing construction.

But Mr Boey believes the Australian economy will slow more than what economists are anticipating as he is predicting a further downturn in the residential housing market and weaker capital investment flows from the miners.

“If we don’t get world gross domestic product growth of 3 to 4 per cent, commodity prices will not go up," he said. “And at current commodity prices, miners won’t continue to spend [on new projects]." Countries that had already undergone a recession, such as China and the United States, were in a better position to stage a rebound, he said.

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The chief investment officer for Equity Trustees, Shaun Manuell, is not as pessimistic about Australia’s outlook, but he believes any rate cut will only provide marginal support to our market. Further, not all interest rate-sensitive stocks will benefit this time round. “The recovery of domestic cyclicals is still too early to call because many still have structural problems that might be greater than the [interest rate] cycle," Mr Manuell said.

For instance, traditional retailers are suffering from the growing popularity of internet-based stores, and rate cuts will do little to influence changing consumer behaviour.

However, further rate cuts are likely to increase the appeal of high-yielding defensive stocks, Mr Manuell added. “Market returns may look flat but if you break it up into segments, a lot of the high yielding sectors have done incredibly well over the last 12 months, and that is a trend that can easily continue," he said.

Aberdeen Asset Management’s head of Australian equities, Rob Penaloza, also cautions against getting too excited about possible rate cuts. “When you are getting rate cuts, it is indicative that the world is still struggling to recover," he said.

Banks should be well placed to benefit from the lower cash rate as it should stimulate demand for loans and increase the attractiveness of their dividends – in theory at least.

Aberdeen is underweight on banking stocks but Mr Penaloza believes it is a mistake to steer clear of all consumer discretionary stocks. As consumers find more cash in their pockets from lower interest rate payments, it should benefit four-wheel-drive accessory supplier ARB Corporation, beverage company Coca-Cola Amatil and lottery company Tatts Group, in his opinion.

The share market should also generally benefit from the fall in deposit rates as it logically would force investors to put their savings to work in the equity market.

However, this is far from a given. Frontier Advisors senior investment consultant, Allison Hill, thinks this is far from a given and she has not noticed any significant investor movement out of cash.

“There is no exact rule about what would work in investing," she said.

“I agree that [rate cuts] should be positive for equities, but you do need to look at the political and economic environment.

“Also those close to retirement will prefer the certainty of cash, even at lower interest rates."

She could not say how low interest rates need to go to force cash back into the market, but suspects rates may need to move closer to the near zero levels in the United States before we see investors move en mass out of cash.